There are a few options open to homeowners for financing residential construction projects, whether it is a new home or a remodel of an existing one. The two most common options are construction loans from a bank or other financial institution, and a home equity line of credit or HELOC. Other options are available, however, such as crowdfunding, finding a money partner, or using tax credits. We’ll look at each of these residential construction project financing options so you can choose which is best for you.
Home construction loanHome construction loans are a secure way to fund your residential construction project. They typically start as a short-term higher-interest loan while the work is being completed, and then transition into a mortgage once the project is finished.
These loans are available at most banks and credit unions. The approval process isn’t too difficult if you have a good credit rating. It is important to note that you aren’t the only one who must qualify for this type of loan: your contractor has to also. The bank will want to review your contractor’s financial standing and past projects to ensure they will be able to complete the project in a timely fashion and with quality work.
Funds from the construction loan are paid out by the financial institution to the contractor as the work progresses, usually in monthly draws. The owner generally makes interest-only payments during construction. These loans often have a higher interest rate while under construction than a regular mortgage. Once the loan is converted to a standard mortgage they are typically paid back over 15-30 years.
There are different types of residential construction loans:
- Construction to permanent – In this arrangement, the construction loan transitions to a standard mortgage at the completion of the project. With only one loan closing, and one set of closing costs to pay, this option can save you money over other loan types.
- Construction only – This type of loan only pays for construction costs during the project. Once the project is complete, the homeowner will need to pay the loan in full or get permanent financing through a mortgage. This option may require two loan closings, which means you would be paying two sets of closing costs.
- Owner-builder construction loan – If you are the homeowner and have the capacity to act as your own contractor, you may qualify for this type of loan. It can take the form of a construction to permanent or construction only loan. However, you will have to prove that you have the skills necessary to perform your own construction. Not all banks will be willing to loan you money in this type of loan, so you may have to do some additional shopping around.
HELOCs or renovation loans are generally used to fund remodels or renovations, not new construction. That’s because they depend on the equity built up in a standard mortgage to provide the funds for the project. They work best for projects that will increase the value of your home.
Home equity line of credit (HELOC)
A HELOC is essentially a second mortgage that you can borrow from and pay back, much like a credit card. It is important to note that you are using your home as collateral for the loan, so if you default on the payments, you risk foreclosure. Also, you will need to have a significant amount of equity in your home before you can take out a HELOC. You can usually borrow up to 85% of your home’s value, minus the amount you owe on your existing mortgage.
One of the advantages of using this type of financing is that you won’t have to present a budget or your builder’s qualifications like you would for a standard construction loan. The approval process is more focused on your ability to pay and your credit rating, rather than the contractor’s ability to perform.
During the draw period, when construction is in progress, you can pay for the work through the HELOC using checks or a card. Interest-only payments are often all that is required in this phase. Once the work is complete and you enter the repayment period, then monthly payments will be made against the principal and the interest. The repayment period often extends for 20 years.
Real estate crowdfundingReal estate crowdfunding is a recent trend in the project funding arena, but it is gaining ground. Like other crowdfunding sites, these sites allow people to pool their investments to fund construction projects. Most of the time, funds are funneled into real estate investment trusts (REITs), which have been around for a while. These companies own, and often operate, real estate ventures such as apartments, warehouses, malls, and hotels. Many people use these sites as part of their overall investment portfolio.
While this type of fundraising has been used primarily for multi-family and commercial properties, there is at least one site that allows investors to be part of smaller residential projects. Patch of Land offers a marketplace that matches investors to projects. They focus on projects that traditional lenders turn away from. The investors must be accredited, so there is less risk for homeowners.
Money partnerFinding a money partner can be as simple as having a rich relative you can call on to help fund your home improvement project, or it can be more structured. There are companies out there looking for property to invest in, and it could be your project is just what they are looking for.
This type of financing seems more suited to larger residential or multi-family projects. There is an application process, and every money partner is going to be looking for different things. Since these partners are often private lenders, be sure you do your research on their practices, so you know what to expect and if they are trustworthy.
Housing tax creditsHousing tax credits are different than the other forms of residential construction project financing that we’ve been looking at. They are targeted at projects that construct or remodel existing low- and moderate-income housing. This housing can take the form of apartments, single-family houses, townhouses, and duplexes, and are generally rental properties.
The federal Low-Income Housing Tax Credit (LIHTC) has been around since 1986 and has helped around 2 million housing units since its inception. Here’s how the credits work:
- The federal government issues tax credits to state governments.
- State housing agencies award the credits to developers of affordable rental housing projects through a competitive process.
- Developers usually sell the credits to private investors to obtain funding for their projects.
- Once the housing project is complete, the investors can claim the tax credits over a 10-year period.